Emil Kalinowski

If the subject of the US dollar is raised by the business media, chances are it will be referred to as ‘the world’s reserve currency’. This is incorrect. Understanding why sheds light on the post-2008 economic lethargy.

The word ‘currency’ is defined by Merriam-Webster as a “medium of exchange”, a thing of “general use, acceptance or prevalence”, “something that is in circulation” and “a common article for bartering”. And yes, the US dollar is the dominant government-issued currency among its peers (e.g., European euro, British pound, Swiss franc, Japanese yen, Canadian and Australian dollars). But no, neither the dollar nor its peers function as the global standard of exchange. Instead, these currencies are merely the denominations of the most widely accepted ‘article’ utilised by the modern economy.

Imagine a Jamaican international coffee distributor receiving a large order for Blue Mountain beans from a new hipster-run Japanese café. If the distributor received a billion-yen worth of (so-called) reserve currency, it would be irritated. What is it going to do with pallets of government-issued currency? Be it yen, dollars, euros or francs, where would it be stored? How will something out of a Hollywood bank-heist movie be transported? What will happen when the distributor attempts to make a deposit at National Commercial Bank Jamaica with 100%-audited, non-counterfeit reserve currency in neatly stacked pyramids? The police would be called!

Transacting with government-issued currencies at any scale slows ‘barter’. These currencies are – or would be, if businesses had not already eliminated them from transactions – an impediment.

The next time ‘Tokyo Smoke’ put in an order, the distributor would think twice about assigning its Blue Mountain inventory to the kissaten.

The bank ledger is the reserve standard

Since throughout most of human history the preeminent money of the day was a physical expression of a political entity (e.g., the Roman denarius, Byzantine solidus, Chinese jiaozi, Dutch guilder, British sovereign), it is natural to presume that physical, political symbols remain the preeminent currency today. But rarely is business conducted in a manner for this to be true anymore. Instead, business is managed via the exchange of ledger balances on bank balance sheets. Ledger balances are the global reserve ‘currency’. The concept of a ‘reserve currency’ – tangible for millennia – is today a reserve ‘currency’ – electronic and ephemeral.

When a Canadian coal exporter sells its briquettes to a South Korean importer, it instructs Royal Bank of Canada to request payment from Shinhan Bank.

It does not instruct the importer to mail a trundle of won, yen or dollars.

The exporter does not want to receive paper bills or gold bullion but ledger balance credits.
Central banks and national treasuries control government-issued currency. But a system of depository, commercial, investment and financial institutions issue ledger balances. The overwhelming majority of money supply, the money that reduces the friction inherent to transactions, the money that is readily accepted, the money that serves as the global reserve ‘currency’, is a bank ledger balance.

Consider this from the Bank of England: “Most of the money in circulation is created, not by the printing presses of the Bank of England, but by the commercial banks themselves: banks create money whenever they lend to someone in the economy or buy an asset from consumers. And, in contrast to descriptions found in some textbooks, the Bank of England does not directly control the quantity of either base, or broad money. Of the two types of broad money, bank deposits make up the vast majority – 97% of the amount currently in circulation. And in the modern economy, those bank deposits are mostly created by commercial banks themselves.”

At modern economic scales, the denomination (e.g., dollars, euros) is not the valuable asset but a measurement of it, much like weight (e.g., kilograms, troy ounces) denominates the quantity of gold.

Shrinking ledgers, ‘money’ and economy

Because the financial media is not aware of this distinction, much time is lost discussing the relative value of denominations while the underlying asset deteriorates.

Since 2007-08, the bank-balance-sheet expansion has stagnated because these institutions are deterred from growing their respective ledger balances by persistent risk.

Stagnant-to-shrinking individual ledger balances produce a stagnant-to-shrinking collective reserve ‘currency’, which in turn results in torpid trade and drowsy economic growth.
Jeffrey P. Snider, the chief investment officer of Alhambra Partners, summarises: “You can then see why global trade downshifted in and around the Great ‘Recession’ and never really came back – though it was predicted to, and everyone, especially in the [emerging markets], was counting on it.

Before the Global Financial Crisis in that eurodollar system, the middle currency was freely available for use anywhere. Nowadays, it’s so much harder to source and maintain funding.

It doesn’t shut off trade completely, but it does slowly squeeze the life out of it over time.
The global regime is starved of its monetary oxygen. That’s why there are no winners; the dollar shortage isn’t a redistribution of demand, it is the slow erosion and even destruction of it.”

The “dollar shortage” Snider references made front-page news last month when America’s central bank was forced to pour $53 billion into an interbank lending market at a moment’s notice because overnight rates for secured funding rocketed to somewhere between 6% and 10% (depending on the data source). The New York Times noted: “The Federal Reserve stepped into financial markets on Tuesday (17 Sept.) to keep short-term interest rates from rising — the first time the central bank has had to carry out this type of ‘market operation’ since the global financial crisis. But the operation was bedevilled by technical difficulties, forcing the Fed to delay the intervention. It was carried out 25 minutes later than initially planned. The New York Fed announced Tuesday that it would conduct a second, similar operation on Wednesday to help keep the fed funds rate in its target range.”

The Federal Reserve had to come back the next day with $75 billion and again on Thursday. By Friday of that week, the central bank had been convinced it had to perform daily $75 billion overnight operations through mid-October while also introducing longer-term (14-day) lending for $90 billion. Unfortunately, insufficient levels of global reserve ‘currency’ continues to put economic activity at risk. Though governments have been trying to make up the difference for a dozen years the chasm has proven, and will likely continue to prove, to be too large.

Emil Kalinowski, CFA, is a member of the CFA Society Cayman Islands board.